ORIGINAL RESEARCH ARTICLE
`
`Pharrnacoeconomics 2002; 20 Suppl. 3: 11-29
`l 170-7690/02/00J3-00l l/$25.00/0
`
`© A dis International Limited. All rights reserved.
`
`Returns on Research and Development
`for 1990s New Drug Introductions
`Henry Grabowski,1 John Vernon 1 and Joseph A. DiMasi2
`1 Department of Economics, Duke University, Durham, North Carolina, USA
`2 Tufts Center for the Study of Drug Development, Tufts University, Boston, USA
`
`Abstract
`
`Background: Previously published research by the authors found that returns on
`research and development (R&D) for drugs introduced into the US mar(cid:173)
`ket in the 1970s and 1980s were highly skewed and that the top decile of
`new drugs accounted for close to half the overall market value. In the 1990s,
`however, the R&D environment for new medicines underwent a number of
`changes including the following: the rapid growth of managed-care or(cid:173)
`ganisations; indications that R&D costs were rising at a rate faster than that of
`overall inflation; new market strategies of major firms aimed at simultaneous
`launches across world markets; and the increased attention focused on the
`pharmaceutical industry in the political arena.
`Objective: The aim of this study was to examine the worldwide returns on R&D
`for drugs introduced into the US market in the first half of the 1990s, given that
`there have been significant changes to the R&D environment for new medicines
`over the past decade or so.
`Results: Analysis of new drugs entering the market from 1990 to 1994 resulted
`in findings similar to those of the earlier research - pharmaceutical R&D is
`characterised by a highly skewed distribution of returns and a mean industry
`internal rate of return modestly in excess of the cost of capital.
`Conclusions: Although the distribution of returns on R&D for new drugs con(cid:173)
`tinues to be highly skewed, the analysis reveals that a number of dynamic forces
`are currently at work in the industry. In particular, R&D costs as well as new drug
`introductions, sales and contribution margins increased significantly compared
`with their 1980s values.
`
`Competition in the research-based pharma(cid:173)
`ceutical industry centres on the introduction of new
`drug therapies. In this paper, we examine the re(cid:173)
`turns on research and development (R&D) for new
`drug entities introduced into the US market in
`the first half of the 1990s. This research work
`builds directly on earlier analyses of returns on
`R&D for the 1970s and 1980s introductions per(cid:173)
`formed by Grabowski and Vernon_[l,21
`
`Our prior analyses indicate that this industry has
`exhibited very skewed distributions of returns. In
`this regard, several significant new classes of drug
`therapies have been introduced since the late
`1970s. Early movers in these classes have obtained
`the highest returns on R&D. We found that the top
`decile of new drugs accounted for close to half of the
`overall market value associated with all the new drug
`introductions in our 1970s and 1980s' samples.
`
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`

`16
`
`Grabowski et al.
`
`latter sub-sample of drugs accounts for a very
`small share of overall sales for the full sample.
`
`Life-Cycle Sales Profiles
`
`Since data were available for the years 1990 to
`2000, 7 to 11 years of worldwide sales values for
`the NCEs in our sample were provided, depending
`on their date of introduction into the US market.
`The next task was to estimate future sales over the
`complete market life of these products. Twenty
`years was chosen as the expected market life. This
`is the same assumption that we utilised for 1980s
`new drug introductions. We believe this to be a
`reasonable time horizon for an IRR analysis. Any
`sales remaining after 20 years of market life are
`likely to be very small, given the sales erosion ex(cid:173)
`perienced by most products from generic competi(cid:173)
`tion and product obsolescence. Furthermore, these
`sales will also be severely discounted by the cost
`of capital in an IRR analysis.
`We utilised a two-step procedure to project fu(cid:173)
`ture sales values. These steps involve forecasting
`sales to the point of US patent expiry and then pro(cid:173)
`jecting sales in the post-patent period. The two(cid:173)
`step approach is illustrated in figure 1 for one of
`the products in our sample. This product was intro(cid:173)
`duced into the US market in 1992. There are 9
`
`800
`
`00
`Q) 700
`:::,
`gi
`0
`0
`0
`8
`<f) 500
`
`600
`
`" ~ .E 400
`
`(f)
`:::J
`y; 300
`·" <f)
`Q) 200
`cl
`<f)
`" ro
`Q)
`2
`
`100
`
`Projected values
`(dashed lines)
`
`··••-
`
`' I!_
`
`• -. ., • • .....
`
`Patent expiry
`
`0 1 2 3 4 5 6 7 8 9 1011121314151617181920
`Sales year
`
`Fig. 1. Actual and projected worldwide sales values for a rep(cid:173)
`resentative sample product.
`
`© Adis International Limited. All rights reserved.
`
`years of sales information and its US patent expires
`in year 12. By year 9, this product was in the mature
`portion of its product life cycle. By using a refer(cid:173)
`ence life-cycle curve, the product was projected to
`have relatively stable sales (in constant dollar
`terms) until year 12. A significant decline is then
`projected in the period after US patent expiry be(cid:173)
`cause of the entry of generic competitors and re(cid:173)
`lated economic factors.
`The estimated sales decline after patent expiry
`is based on the experience of major commercial
`products coming off patent in the 1994 to 1997
`period. In particular, we examined worldwide sales
`losses for a sample of NCEs for a 4-year period
`following their US patent expiry. The average per(cid:173)
`centage declines observed were 31, 28, 20 and
`20%, respectively. We utilised these percentages
`to project sales in the first 4 years after patent ex(cid:173)
`piry and, thereafter, a 20% decline until the prod(cid:173)
`uct's market life is completed in year 20. In our
`prior work, we found that generic competition is
`focused on products with significant sales at the
`time of US patent expiry. Consequently, for the
`drugs concentrated in the bottom four deciles of
`our sample (with worldwide sales of less than
`$US40 million in year 10 of their market life), we
`assume that the probability of generic competition
`is very low. For these drugs we assume that sales
`losses in the mature phase of cycle will proceed at
`a more moderately declining rate based on the ref(cid:173)
`erence curve used for the pre-patent expiry period.
`We should note that the percentage declines in
`sales from generic competition in the US market
`observed in prior studies are much greater than the
`worldwide losses in sales for major commercial
`products observed here.l16l Hence, the decline in
`worldwide sales in the post-patent period is amel(cid:173)
`iorated by the lower incidence of generic competi(cid:173)
`tion and sales losses outside the US. This may
`change by the time this cohort actually reaches
`patent expiry during the current decade, because
`reference pricing and generic competition are on
`the rise in many European countries.l17l
`Figure 2 provides a plot of the sales life-cycle
`profile (in $US, 2000 values) for the top two dee-
`
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`R&D Returns for 1990s New Drug Introductions
`
`17
`
`3000 □ 1st Decile
`.i. 2nd Decile
`0 Mean
`■ Median
`
`00
`Q) 2500
`:::,
`cl
`>
`0
`0
`0
`8
`
`2000
`
`<f) " ~ 1500
`.E
`
`(f)
`
`:::J 1000
`y;
`·" <f)
`
`Q)
`cl
`(f)
`
`500
`
`0
`
`1 2 3 4 5 6 7 8 9 1 0 11 12 13 14 1 5 16 17 18 19 20
`Sales year
`
`Fig. 2. Worldwide sales profiles of 1990 to 1994 new drug in(cid:173)
`troductions.
`
`iles as well as the mean and median drug com(cid:173)
`pounds in our 1990 to 1994 sample. The sales
`curves illustrate the highly skewed distribution of
`sales in pharmaceuticals that was observed for
`early cohorts. The peak sales of the top decile com(cid:173)
`pounds are several times the peak sales of the
`second decile compounds. The mean sales curve
`is also significantly above the median.
`Figure 3 provides a plot of mean worldwide
`sales for the 1990s sample compared with that for
`the 1980s cohort (in $US, 2000 values). Mean
`sales have increased significantly in real terms,
`with peak sales increasing from $US345 million
`for the 1980s cohort to $US458 million for the
`1990s cohort. There is also the suggestion that
`sales curves have become somewhat steeper in the
`ascending sales growth stages of the life cycle,
`with a longer plateau before generic competition
`and product obsolescence take hold.
`Figure 4 shows a corresponding plot of the
`mean worldwide sales for the top decile com(cid:173)
`pounds in the 1990 to 1994 and 1980 to 1984 pe(cid:173)
`riods. This is instructive, given that the prospective
`returns for top decile compounds are primary driv(cid:173)
`ers of R&D investment activities in pharmaceuti(cid:173)
`cals . For the 1990s cohort, the top decile com(cid:173)
`pounds reached peak sales of more than $US2.5
`
`© Adis International Limited. All rights reserved.
`
`billion. This may be compared with peak sales of
`near $US 1.8 billion for the 1980s cohort. The peak
`sales for the 1990s cohort also occur later than for
`the 1980s cohort.
`
`Pre-Tax Contributions and Other
`Economic Parameters
`
`The next step in the analysis was to obtain rev(cid:173)
`enues net of production and distribution costs ( of(cid:173)
`ten categorised in the economic literature as
`'quasi-rents'). For this purpose, we analysed pre(cid:173)
`tax contribution margins in pharmaceuticals dur(cid:173)
`ing the 1990s. As in prior work, we utilised data
`derived from the income statements of the pharma(cid:173)
`ceutical divisions of a number of major multina(cid:173)
`tional drug companies to obtain representative
`values on contribution margins over timeP.2l
`Our analysis of the data on these firms indicated
`that average contribution margins gradually in(cid:173)
`creased from 42% in the early part of the 1980s to
`approximately 45% at the end of the decade. On
`the basis of these data, we constructed a linear con(cid:173)
`tribution margin schedule over time. In particular,
`the contribution margin is 42% in the first year of
`the product life and grows by increments of 0.3%
`
`500
`
`□ 1990-1994
`
`Q)
`
`00
`.:! 400
`~
`0
`0
`0
`8
`
`300
`
`<f) " ~ .E
`
`(f)
`:::J
`y;
`
`·" <f)
`
`Q)
`cl
`<f)
`" ro
`
`Q)
`~
`
`200
`
`100
`
`0
`
`1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
`Sales year
`
`Fig. 3. Comparison of mean worldwide sales curves for new
`drug introductions in the 1990 to 1994 and 1980 to 1984
`samples.
`
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`

`18
`
`Grabowski et al.
`
`3000
`
`□ 1990-1994
`O 1980-1984
`
`2500
`
`00
`Q)
`:::,
`cl
`>
`0
`2000
`0
`0
`~
`
`<f) " ~ .E
`
`(f)
`:::J
`y;
`
`·" <f)
`
`Q)
`cl
`(f)
`
`1500
`
`1000
`
`500
`
`1 2 3 4 5 6 7 8 9 1 0 11 12 13 14 1 5 16 17 18 19 20
`Sales year
`
`Fig. 4. Comparison of mean worldwide sales curves for top
`decile drugs in the 1990 to 1994 and 1980 to 1984 samples.
`
`per year. We also assume that contribution margins
`will continue to rise at this same rate during the
`current decade. Hence, over the full 20-year life
`cycle, target contribution margins are expected to
`rise from 42 % in year one, to 48% by year 20, with
`a mean contribution margin of 45% over the full
`life cycle.
`While we constrained margins to average 45%
`over the life cycle, we also recognise, as in our
`earlier analyses, that promotion and marketing ex(cid:173)
`penditures are concentrated in the launch phases of
`the life cycle. In our prior analysis, we developed
`the following allocation rule based on a regression
`analysis of promotional and marketing outlays:
`promotion and marketing is equal to sales in year
`1, declines to 50% in year 2, and falls to 25% in
`year 3. We retained this assumed pattern on mar(cid:173)
`keting outlays in the present analysis. Interviews
`with industry participants indicated that the initial
`post-launch years continue to be the primary focus
`of marketing and promotion activities.
`An analysis performed by Rosenthal et aU18l
`indicates that the drug industry's marketing ex(cid:173)
`penses to sales ratios have remained relatively
`stable around 14% in the 1996 to 2000 period. How(cid:173)
`ever, there were some important compositional
`
`© Adis International Limited. All rights reserved.
`
`shifts over this period. The direct-to-consumer ad(cid:173)
`vertising to sales ratio increased from 1.2 % to 2.2 %
`between 1996 and 2000, at the expense of physi(cid:173)
`cian detailing and hospital medical journal adver(cid:173)
`tising.[lSJ
`For the current analysis, we did make one rela(cid:173)
`tively minor change in the allocation and timing of
`marketing expenditures related to launch. In par(cid:173)
`ticular, we estimated pre-marketing launch expen(cid:173)
`ditures in the order of 5 and 10% of first year sales
`in the 2 years immediately prior to launch. These
`marketing expenditures are for activities such as
`pre-launch meetings and symposiums, pricing and
`focus group studies, and sales force training. Our
`assumptions concerning the size and timing of
`these expenditures were guided by a recent survey
`report on pre-launch marketing expenditures by in(cid:173)
`dustry consultants as well as interviews with some
`of the participating companies.l19l
`As indicated above, our model is structured so
`that margins average 45% over the full product life
`cycle. Given the assumed pattern of launch expen(cid:173)
`ditures, contribution margins for each product
`are below representative industry values in the
`first 3 years of marketing. However, as a product
`matures, both promotional and administrative
`costs decline in relative terms, and contribution
`margins increase over average industry values in
`the later years of the life cycle.
`The model is also structured to provide for cap(cid:173)
`ital expenditures on plant and equipment (P&E).
`As in our model for the 1980s cohort, we assumed
`overall capital expenditures for P&E to be equal to
`40% of tenth year sales . Half of these outlays are
`assumed to occur in the first 2 years before market(cid:173)
`ing and the other half during the initial 10 years of
`the product's market life. These assumptions imply
`an average capital investment to sales ratio of 3.3%
`over the full product life cycle. This is generally
`consistent with data from pharmaceutical industry
`income statements.
`In particular, we checked the reasonableness of
`our assumptions by comparing this implied 3.3%
`capital investment to sales ratio with the corre(cid:173)
`sponding ratios observed on industry income state-
`
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`R&D Returns for 1990s New Drug Introductions
`
`19
`
`ments during the 1990s. We found that the drug
`industry capital investment to sales ratio averaged
`about 7.0% during the 1990s. However, the latter
`value includes investment for R&D as well as
`production, marketing and administrative facil(cid:173)
`ities. In our model, provisions for capital invest(cid:173)
`ment in R&D facilities are included in the cost
`estimates provided by DiMasi et aU5l Accord(cid:173)
`ingly, we asked some industry members involved
`with strategic planning for information on what
`percentage of their P&E expenditures was devoted
`to R&D, versus other firm activities. We obtained
`a range of 40 to 50% of total capital expenditures
`devoted to R&D. Given this range, the capital in(cid:173)
`vestments to sales ratio for non-R&D activities
`implied by our model is consistent with the ob(cid:173)
`served data from company income statements.
`For working capital, it was assumed that ac(cid:173)
`counts receivables are equal to 2 months of annual
`sales and inventories are 5 months of sales (valued
`at manufacturing cost). These are also based on
`the analysis of balance sheet data of major phar(cid:173)
`maceutical firms. Working capital is recovered at
`the end of the final year of product life.
`
`Effective Tax Rates
`
`Our analysis of returns is conducted on an af(cid:173)
`ter-tax basis. In our prior studies of returns, we
`computed average effective tax rates based on
`analysis of income statement data from eight major
`pharmaceutical firms. The average effective rate
`was 35% for the 1970s cohort and 33% for the
`1980s cohort. A comparable analysis for the 1990s
`cohort yielded an effective tax rate of 30%. This is
`the rate used in our baseline case. The difference
`between the nominal corporate tax rate (34%) and
`the average effective tax rate of 30% reflects var(cid:173)
`ious credits and deferrals such as the R&D tax
`credit and manufacturing tax credits for plants in
`Puerto Rico.l2l
`After-tax cash flows are also influenced by the
`tax treatment of depreciation. In our analysis, cash
`flow in each year is equal to after-tax profits, plus
`depreciation charges. Accelerated depreciation, as
`specified in the US tax code, results in tax deferrals
`
`© Adis International Limited. All rights reserved.
`
`and positive cash flow in the early years of a prod(cid:173)
`uct's market life. This reverses in the latter years
`of a product's life.
`
`Summary of Economic Values
`
`Table II provides a summary of the key eco(cid:173)
`nomic inputs to IRR and NPV analysis for the 1990
`to 1994 NCEs cohort compared with the corre(cid:173)
`sponding values for the 1980 to 1984 cohort. R&D
`investment levels have roughly doubled in real
`terms, in both uncapitalised as well as capitalised
`dollar terms. On the revenue side of the equation,
`sales-life curves have shifted upward significantly.
`This is reflected in higher peak sales for the 1990
`to 1994 cohorts ($US458 million compared with
`$US345 million for 1980 to 1984 NCEs ). While
`sales have not grown at the same rate as R&D
`costs, contribution margins have increased in the
`1990s, implying higher operational profits from a
`given level of sales. How all these factors balance
`out from a returns-on-investment standpoint is a
`major issue addressed in the analysis that follows.
`The industry's cost of capital, effective tax rate,
`and capital investment-to-sales ratio have changed
`only marginally for the current cohort compared
`with the 1980s sample.
`Table II suggests that R&D investment expen(cid:173)
`ditures are growing over time relative to sales rev(cid:173)
`enues and the other activities of pharmaceutical
`
`Table II. Key economic values for internal rate of return analysis
`for the 1990 to 1994 versus 1980 to 1984 new chemical entities
`(NCEs)
`
`1990 to 1994
`
`1980 to 1984
`
`$US416 mil
`$US480 mil
`$US458 mil
`45%
`11%
`30%
`3.3%
`
`$US196 mil
`$US251 mil
`$US345 mil
`40%
`10.5%
`33%
`3.4%
`
`Economic parameter
`Average R&D costs•
`pre-tax uncapitalised
`after tax capitalised
`Peak sales for mean NCE•
`Contribution marginb
`Cost of capital
`Effective tax rate
`Capital-to-investment sales
`ratio
`a R&D costs and sales are all expressed in 2000 values.
`b Average contribution margins over the full product life cycle;
`launch costs are concentrated in early phases of life cycle,
`so margins are lower in initial years and higher in later years.
`mil = millions; R&D = research and development.
`
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`

`20
`
`200
`
`150
`
`Grabowski et al.
`
`Market introduction
`
`100
`
`00
`Q)
`:::,
`cl
`>
`0
`0
`0
`~ 50
`
`<f) " ~ .E
`
`(f)
`:::J
`y;
`
`0
`
`-50
`
`-11-10-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
`Year
`
`Fig. 5. Cash flows over the product life cycle: baseline case.
`
`firms. This issue is discussed further in 'Drug In(cid:173)
`novation and Industry Evolution Since 1970'. This
`increase in industry research intensity can be inter(cid:173)
`preted both as a response to increasing profit op(cid:173)
`portunities from new drug research as well as an
`equilibrating factor bringing returns in line with
`the industry cost of capital. This makes the ques(cid:173)
`tion of industry returns on new drug introduction
`in the 1990s a particularly interesting question to
`analyse at the present time.
`
`Empirical Results
`
`The Baseline Case
`
`Using the data and assumptions described
`above, we constructed the pattern of cash flows
`for the mean of our sample of 118 NCEs shown
`in figure 5. The R&D phase lasts for 12 years and
`results in a stream of negative cash flows. The first
`years of marketing, years 1 and 2, are also charac(cid:173)
`terised by negative cash flows. This is because of
`heavy promotion and advertising expenditures
`during the product launch period. Cash flows rise
`to a peak in year 12 and then begin to decline. The
`decline becomes steeper as patent expiry and ge(cid:173)
`neric competition begin.
`
`© Adis International Limited. All rights reserved.
`
`The baseline case results are shown in the first
`row of table III. The IRR is 11.5% and can be com(cid:173)
`pared with our real cost-of-capital estimate of 11 %.
`Hence, the industry mean performance is positive
`but only by a small amount. The present value of
`net revenues at the date of marketing is $US525
`million and can be compared with the present value
`of R&D costs at the same point in time, or $US480
`million. This leads to an NPV of $US45 million.
`The results for the baseline case for the 1990 to
`1994 NCEs are roughly the same as for our earlier
`1980 to 1984 sample. In the 1980 to 1984 baseline
`case, the IRR was 11.1 % compared with a cost of
`capital ofl0.5%. The 1990 to 1994 IRR is similarly
`about a half percentage point above the cost-of(cid:173)
`capital estimate.
`
`Sensitivity Analysis
`
`Given the uncertainty surrounding many of the
`key parameters that affect the IRR and NPV, we
`have performed a sensitivity analysis for a number
`of the parameters. These results are reported in
`table III.
`An important parameter is the contribution mar(cid:173)
`gin. As discussed earlier, we examined data for a
`number of firms during the 1990s and found that
`
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